Confident that the outlook for the worlds biggest economy is brightening, the Federal Reserve has paved the way for an end to its stimulus programme and, after a bout of market turmoil last year, investors seem prepared for the shift. But the US central banks effort to return to pre-crisis policy settings still represents a huge leap in the dark as it exits from an unprecedented bout of money printing. An ill-judged move could threaten economic revival worldwide, just one of the dilemmas facing policymakers from America, Europe and Asia as they gather this week for an annual World Economic Forum meeting in Davos.
Protagonists will include US Treasury Secretary Jack Lew, Japanese Prime Minister Shinzo Abe, European Commission President Jose Manuel Barroso and central bankers Mark Carney, Mario Draghi and Haruhiko Kuroda. A senior leader from China is also expected. Broadly, the risks they face are slower-than-expected US growth, euro zone deflation, an absence of structural reforms in Japan, and bad loans in China. There will doubtless be others.
While the Fed is trying to normalise monetary conditions to avoid a credit bubble, China is trying to implement financial sector reforms to bring one to an end, said Michael Spencer, economist at Deutsche Bank. Both potentially threaten the sustainability of growth.
The balance of risks for this year may be tilted towards the United States and the euro zone, even if the policy challenges facing Japan and China appear greater. Investors have already priced in a lot of good news, with European shares hitting a 5-1/2 year high last week. The risk is that weaker-than-expected growth could knock markets and unsettle the global recovery. What could trigger a correction is that growth turns out to be weaker than markets have discounted, said Andrew Bosomworth, a senior portfolio manager at Pimco, the worlds largest bond fund. In the case of equities, markets have discounted some pretty rosy economic conditions.
The challenge for policymakers in the United States and Europe is to manage policy expectations at a time when inflation is not performing as expected. Some Fed officials worry tepid price rises mean the US recovery is not as solid as it seems. With growth and job creation should come inflation. Given that uncertainty, US central bankers must convince hesitant consumers that even if the era of quantitative easing is drawing to a close, an interest rate rise remains a long way off.